How to Help Employees Avoid 401(k) Withdrawal Penalties
A quick guide with answers to frequently asked questions about 401(k) withdrawals.
In an ideal world, employees would diligently save through their 401(k) plan and only withdraw their money in retirement. In reality, financial needs—like paying for college or buying a new home—may tempt employees to raid their retirement savings. As an employer, you can clearly explain the risks of early withdrawals so your employees can make educated decisions about their future. Here’s a quick guide with answers to frequently asked questions about 401(k) withdrawals.
Frequently Asked Questions
Can I withdraw money from my 401(k) plan before retirement?
If you’re still at your job, you typically may not withdraw money from your 401(k) account unless your plan allows hardship withdrawals to pay for immediate and serious financial needs. (Some plans do allow for other in-service distributions, but these are typically restricted to employees over age 59-½. In any case, the point is clear: retirement savings are meant for, well, retirement).
However, if you leave your job, you can withdraw money from your 401(k) account, but it may cost you. That’s because your 401(k) plan is designed to help you save for a more comfortable retirement, and if you use it for another purpose, the IRS will penalize you.
In fact, you’ll typically pay a 10% early withdrawal penalty if you withdraw money before reaching age 59½. Plus, you’ll pay income taxes on the distribution. If you invested in a Traditional 401(k), you’ll pay taxes on the full amount, and if you invested in a Roth 401(k), you’ll pay taxes on any earnings.
Here’s how it works. Let’s imagine that you contributed $5,000 to your 401(k) account, and when it grows to $7,500, you decide to withdraw the full amount to pay a hospital bill.
- If you invested in a Traditional 401(k)…
Your entire $7,500 withdrawal will be subject to taxes in addition to a $750 (10%) 401(k) withdrawal penalty if you’re younger than age 59 ½.
- If you invested in a Roth 401(k)…
You would only pay taxes on the $2,500 in earnings—not on the $5,000 in contributions—however, you would still need to pay the $750 penalty if you’re younger than age 59 ½.
Because an early withdrawal from your 401(k) plan could severely derail your retirement, you should only consider it as your absolute last resort.
What are the long-term financial consequences of an early 401(k) withdrawal?
Consider this: If you were in the 24% tax bracket, a $7,500 early withdrawal from a Traditional 401(k) will cost you $1,800 in taxes and $750 in penalties for a total of $2,550, leaving you with just $4,950.
But that’s just the beginning of the price you may pay because when you withdraw funds early, you also miss out on the power of compounding, which is when your earnings accumulate to generate even more earnings over time.
In this case, if you kept that $7,500 invested for 35 years, you could see it grow to $56,218!*
*Projected balances estimated using Betterment’s goal projection methodology.
If you leave your company and are tempted to “cash out” your 401(k) plan, consider rolling it into an IRA or your new employer’s 401(k) plan instead. By doing so, you’ll benefit from tax-deferred or tax-exempt compounding and set yourself up for a brighter future.
Are there any exceptions to the 10% early 401(k) withdrawal penalty?
Yes, the IRS does allow some exceptions to the 10% early withdrawal penalty. These penalty-free withdrawals include:
- Rollover—If you roll over your money to another eligible retirement plan within 60 days. (Beware the “indirect” rollover, which may complicate issues and result in additional penalties if you’re not careful.)
- Death—If your beneficiaries receive a distribution from your 401(k) plan after your death
- Disability—If you become severely disabled and can show documentation of that fact from a physician
- Medical expenses—If your early 401(k) withdrawal is to pay for medical expenses not reimbursed by health insurance that exceed 10% of your adjusted gross income
- Qualified Domestic Relations Order (QDRO)—If distributions are to an alternate payee such as a child or former spouse following a divorce or separation
- Active duty military—If you are a reservist who is called to active duty for a period longer than 179 days or for an indefinite time
- Separation from service—If you are laid off, fired, or quit between age 55 and 59 ½ (However, this 10% penalty exemption only applies to assets in your most recent employer’s 401(k), or any other employer you left at/after age 55. If you withdraw assets from old 401(k)s with former employers, you’ll still have to pay the penalty.)
- Substantially Equal Periodic Payments (SEPP)—If you plan your withdrawals to meet SEPP requirements for a period of five years or until you turn 59½, whichever comes later
What is a hardship withdrawal?
If you need to take a withdrawal from your 401(k) plan account while you’re still with your employer, you may be eligible to take a hardship withdrawal if your plan offers it. The amount of money you can withdraw must be limited to the size of the need, and you will need to document and maintain proof of the need (even if you aren’t asked to provide proof when you request the withdrawal). For example, some plans offer hardship withdrawals to pay for:
- Qualified medical expenses
- Costs related to purchase of principal residence (for employee only, excludes mortgage payments)
- Tuition and education expenses
- Funeral expenses
- Costs to repair damage to principal house
- Costs to prevent eviction or foreclosure of primary residence
- Disaster relief
Like any early withdrawal, you will be taxed, and IRS rules will govern whether you pay the 10% 401(k) withdrawal penalty. Consult your 401(k) plan’s rules for guidance on whether hardship withdrawals are available.
How do 401(k) loans work?
Some plans allow you to take a loan from your 401(k) account, but before you do, think about these important considerations:
- Most companies only allow loans to current employees. That means it’s unlikely that you’ll be able to take a loan from an old plan; however, you can roll your old balance into your current 401(k) plan and then take a loan.
- You may only borrow up to $50,000 or 50% of your vested account balance (the amount that belongs to you, which does not include any company matching contributions that have not yet vested).
- You must repay the loan through after-tax payroll deductions. Typically, the repayment term is five years or less. However, if you are using the money to purchase your principal residence, the repayment period may be longer.
- You pay yourself interest. Your 401(k) plan’s rules will determine the formula (for example, one point above prime). However, the interest may not be enough to make up for earnings you would have generated if you didn’t take a loan.
- Many plans limit you to having only one loan at a time, in which case you must repay your outstanding loan in full before taking another.
- If you leave your job while you have an outstanding loan, you likely need to repay it immediately. If you don’t, it will be categorized as an early distribution and you’ll owe income taxes and the 10% 401(k) withdrawal penalty.
What are some good alternatives to taking a withdrawal or loan from my 401(k) plan account?
Before you take an early withdrawal from your 401(k) plan account—and potentially do something you might regret—consider another option, for example:
- Alter your lifestyle—Whether you cut the cord on your cable subscription or transfer your credit card balance to a lower interest card, simple changes can save you money.
- Work a side hustle—Consider turning a hobby like baking or coaching tennis into a paying gig or think about subletting an extra room in your home.
- Look at other loan sources—If you have a significant amount of equity in your home, a home equity loan may be a cost-effective way to free up the money you need. However, be sure you understand the closing costs and other fees and are comfortable with the idea of putting your home at risk. Also know that certain early withdrawal penalties, like those for principal residence purchase or higher education expenses, are waived when withdrawn from an IRA, but not when withdrawn from a 401(k).
If you need to dip into retirement accounts, a financial advisor will be able to help you understand which accounts to draw from and in which order to help you avoid or minimize unwanted taxes and penalties.
Are there any other withdrawal penalties I should know about?
In addition to the early withdrawal penalty, the IRS also assesses a penalty if you begin taking distributions too late. Specifically, the IRS requires that you begin taking withdrawals—known as required minimum distributions—from your 401(k), IRA, and other qualified retirement accounts once you reach age 72 (prior to January 1, 2020, these distributions were required once you reached age 70-½).
This requirement exists because the government wants to ensure they receive the income tax owed on the money you have saved tax-free. It’s important to note that if you’ve invested in a Roth 401(k), you must take required minimum distributions; however, if you roll your money into a Roth IRA, you can avoid this requirement.
How You Can Help
Now that you have a better idea of how to answer your employees’ questions about 401(k) withdrawals, it’s time to be proactive. Instead of waiting for employees to come to you, consider hosting a meeting or sending an email to remind your employees of the ramifications of taking a plan loan or withdrawal.
Wondering how to educate your employees about the plan? Betterment can help. As a full-service partner, we provide everything from compliance testing to communication support to ensure your 401(k) is effective as possible—and your employees have the support they need to succeed.
Better for your employees. Better for your business. Betterment for Business.
Let’s talk today.
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